Discounted Cash Flow by hqh17862

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									Discounted Cash Flow (DCF)
         Tutorial
    Wednesday, January 31st, 2007
           Tutorial Objectives
• Basic Underlying Principles
  – Time Value of Money
  – Present/Future Value
  – Opportunity Cost
• What is a business worth?
• What is Free Cash Flow?
• Basics of DCF Analysis
  – Compostion
  – Computation
  – Forecasting
                  Present Value
• Time Value of Money: A dollar today is worth more
  than a dollar tomorrow.
   – A dollar today can be invested to earn a rate of return or
     interest.
• What is today’s dollar worth tomorrow (future value)?
                   ( )
                 FVPV i N
                    1
• What is tomorrow’s dollar worth today (present value)?

                 FV
                PV /( i
                    1 )              N
         Time Value: Example
• You are given $5,000 and decide to invest it in
  the stock market for 10 years and expect an
  average annual rate of return of 10%. What is
  that $5,000 worth 10 years from now?
         000
            ,
            5 ( %)
           $
        FV * 10 1                 10
                                    years


          12
        FV $ ,969
• Likewise…         12 
                  , 1
                   $969
                PV /( %)  10                yea
                                           10

                  5
                PV $ ,000
      What is a Business Worth?
• A business is worth the present value of the
  expected future cash flows of the business.
• A company's stock price is a reflection of the
  market's concensus expectation regarding the
  value of the equity in the business.
  Ex. Target Corp (TGT):
     $60 Share Price
     x 858.89 Shares Outstanding (mm)
     = $51,533 Market Capitalization or Market Value of Equity
• Is the market always right?
               Capital Budgeting
• The process of determining how a firm should allocate scarce
  resources to available long term investment opportunities
• Decisions whether a company should undertake a given project
• Goal: Increase (Maximize) shareholder wealth
• One capital Budgeting tool is NPV

              er
             Ya 0           er
                           Ya 1         er
                                       Ya 2      er
                                                Ya 3
             $ 00 0
            ( 3, 0)         30 0
                           $, 0        1, 0
                                      $ 00 0    2, 0
                                               $ 50 0

        is o n ae
       D c u t Rt :             0
                               1%
        e r s n au
       Nt Pe e t V l e      $2. 9
                           ( 2 53 )
                 Discount Rate
• The interest rate at which you discount
  expected future cash flows to the present
• Efficient Markets Hypothesis (EMH)
  – Finance theory which states that all stock market
    prices at any given time reflect the accurate present
    value of the future cash flows of a business
  – Assumes market as a whole has rational
    expectations and is always right
  – Uses Capital Assets Pricing Model (CAPM) to
    establish the theoretical 'cost' of equity
                 Discount Rate
• EMH uses Beta as a measure of risk by
  quantifying the stock's volatility (up and down
  movements) relative to the market.
  – Since the stock price reflects the PV of future cash
    flows, the more volatile the stock price, the more
    uncertain the future performance of the business.
  – This 'extra risk' is reflected in a higher Cost of
    Equity. (Risk/Return)

     Cost of Equity = Rf + B * (Mkt – Rf)
               Discount Rate
"I'd be a bum on the street with a tin cup if the
markets were always efficient" – Warren Buffett

• The Opportunity Cost of Money –
  – Also known as the Hurdle Rate
• The expected rate of return available on
  alternative investment opportunities
  – Historically, the stock market has generated an
    average annual return of about 10%.
   Discounted Cash Flow Analysis
• Same Concept as capital budgeting: Is a $60 per
  share ‘initial investment’ in Target Corp. worth the
  projected future cash flows of this business given a
  discount rate of 10%?
• Instead of a CFO conducting Capital Budgeting
  analyses to evaluate the projected cash flows of
  projects for his/her company to invest in, we are a
  fund conducting DCF analyses to evaluate the
  projected cash flows of whole companies.
 Free Cash Flow – Equity (FCFE)
• Net Income adjusted for all non-cash sources
  of revenue and expense, less capital
  expenditures
  – Ex. Subtract all revenue paid for on credit, and add
    all expenses paid for on credit
  – Add back depreciation – largest non-cash expense
• The cash that is left for shareholders after debt-
  holders have been paid and necessary
  reinvestment has been made
• FCFE is what we care about!
 Free Cash Flow – Equity (FCFE)
Net Income

Add: Depreciation
Less: Capital Expenditures (CAPEX)

= Free Cash Flow to Equity
                          DCF Example
Lemonade Stand Business

                     Year 0      Year 1     Year 2     Year 3
Initial Cost     (50,000)
Operating Income                  75,000     84,000    100,000
Taxes (34%)                      (25,500)   (28,560)   (34,000)
Income                           $49,500    $55,440    $66,000
Plus: Depreciation                 3,750      4,200      5,000
Minus: CapEx                       4,500      5,040      6,000
Free Cash Flow       ($50,000)    $48,750    $54,600    $65,000
Discount Rate            10%
Discounted Values ($50,000)       $44,318    $45,123    $48,835
Present Value         $88,277
            Terminal Cash Flow
• Going Concern Assumption: The business will
  operate and generate cash flows indefinatley.
  – Zero Growth: CF / i
     • $48,835/0.10 = $488,350
  – 5% Growth: CF*(1+g) / (i-g)
     • $48,835*(1.05)/(.05) = $1,025,535
• Liquidation: Sell off remaining assets in
  liquidation.
  – PV of Fixed Assets: $52,590/(1+10%)^3
       =$39,511
        Forecasting Cash Flows
• Historical performance is not important in terms
  of business value, but is important in terms of
  predicting future performance.
• The trickiest part of business valuation
  – Future performance is unknowable
• Things to consider when predicting the future:
  – Every projection should be backed by a rational
    argument
  – The strongest arguments will include both
    quantitative and qualitative support
  – Mean Reversion
          Forecasting Cash Flows
• Historical Simple/Weighted Averages
  – Primarily used when there is no discernable trend,
    or current trend is not expected to continue
                      Year 1   Year 2   Year 3   Year 4   Year 5
  Net Income Growth    7%       12%      8%       1%       5%

  Simple Average                        6.60%

  Weighted Average    Weight  Growth
                        33.3%     5%      1.7%
                        26.7%     1%      0.3%
                        20.0%     8%      1.6%
                        13.3%    12%      1.6%
                         6.7%     7%      0.5%
                       100.0%             5.6%
          Forecasting Cash Flows
• Historical Trend Exrapolation


                        Year 1   Year 2   Year 3   Year 4   Year 5
  Net Income Margin      4%       4%       4%       5%       6%


                        Year 6   Year 7   Year 8   Year 9   Year 10
  Estimated NI Margin    6%       7%       8%       8%        8%
          What We've Covered
• Basic Underlying Priciples
  – Time Value of Money
  – Present/Future Value
  – Opportunity Cost
• What is a business worth?
• What is Free Cash Flow?
• Basics of DCF Analysis
  – Compostion
  – Computation
  – Forecasting

								
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